The odds are still stacked against individual investors, but if you're willing to look outside the world of income stocks, contrarian funds may be a good investment, writes Kevin McDevitt of Morningstar FundInvestor.

With money rushing into index funds, active contrarians may offer a way to cut risk.

These funds may be of special interest to risk-averse investors who want equity exposure but are concerned about market risk. That’s understandable, since the whole notion of market risk has been turned upside down in recent years, not just by frightful headlines, but also by the headlong rush into passively managed index vehicles, open-end funds, and ETFs alike.

Nearly $575 billion, or more than 20% of beginning assets, left actively managed US stock funds from May 2006 through August 2012. Over that same span, passively managed vehicles collected $350 billion. As a result, passive fund market share has roughly doubled over the past ten years to 33% of US stock fund assets.

The problem with the increasing popularity of index funds is that it could diminish some of their virtues. To be sure, the case for index funds is very compelling. They offer low costs, broad diversification, and generally competitive risk-adjusted returns versus category peers without much manager risk (that is, the risk that a fund manager underperforms his index).

But flows into passively managed funds have arguably diminished the benefits of diversification and increased risk in equity markets. In a paper published this spring in the Financial Analysts Journal, Rodney Sullivan at the CFA Institute and Morningstar Investment Management’s James Xiong argue that ETF flows in particular have contributed to increased correlations among stocks, as they increasingly trade as part of index baskets rather than individually.

They estimate that ETF trading now accounts for roughly one-third of all trading in the US. Sullivan and Xiong also found that the average beta (a measure of market volatility) increased across all equity segments from 1997 to 2010.

Just as significantly, betas across market caps (large versus small) and styles (value versus growth) have converged over the past ten years. As a result, not only have betas risen over the years, but diversification benefits across market cap and style have fallen.

Crucially, Sullivan and Xiong also discovered “a meaningful relationship between passive investing and a rise in market risk as proxied by various market betas.” It’s reasonable to wonder whether the increased correlations during the 2000-2002 and 2007-2009 bear markets explain these trends, but bear in mind that these were only four of the 14 years studied. Correlations increased across all market environments.

Time to Get Active?
For investors looking to insulate themselves from this convergence, it may be time to consider going against the grain.

With US stocks increasingly moving together, funds that look less like the popular indexes—as defined by active share—may be in a better position to weather market swings. And with overall market volatility increasing, it arguably makes sense to define risk more in absolute terms, as many truly active funds do, rather than in relation to an index.

Tickers Mentioned: FEVAX, AMANX, BBTEX, FMIHX, MMM